[Please note that the views presented by individual contributors are not necessarily representative of the views of ATCA, which is neutral. ATCA conducts collective Socratic dialogue on global opportunities and threats.]

The Chinese character "Zhang", which means "inflate", has emerged as the word of the year on the Chinese internet.

Massive Food Inflation

Around Shanghai, the price of certain food products has risen by at least 50 percent in the past year, sparking anger amongst the poorer shoppers who spend up to half of their income on food. In some parts of China, the price of basic foods has doubled -- gone up by 100 percent -- and shoppers in the southern city of Shenzhen have been reported to skip across the border to Hong Kong to buy their daily groceries!

China's paper money

Chinese Prime Minister on Radio and Television

Wen Jiabao, the Chinese prime minister, has taken the rare step of appearing on national radio to reassure the public, "I can tell everybody, the government has complete confidence in tiding over this difficult stage together with the masses." Responding to a caller angry about rising prices, Mr Wen added, "Indeed, in recent times prices have risen across the nation and under these circumstances the lives of low and middle-income earners are evidently more difficult." "The central government has taken a slew of steps to stabilise prices. We will put it higher up on our agenda," state television quoted Mr Wen as saying in a New Year trip, repeating the top leadership's line since inflation hit a 28-month high in November.

China's Central Bank Governor in Media

China's central bank governor Zhou Xiaochuan has warned that inflation is mounting and that more could be done to guide the growth of money. Mr Zhou said, "Our country is also facing rising inflationary pressure and expectations... the quantitative easing policies adopted by the US and other major economies have a noticeable spill-over effect on international liquidity, which further intensifies imported inflationary pressure." He added that the central bank was also considering raising capital requirements for "systematically important" Chinese banks to cut risks in the banking sector.

Double Digit Inflation and Record Property Prices

Inflation is rising at double digits in China, if one observes its incremental sequential growth month-on-month, especially over the last two months. Along with record property prices, this has sown public discontentment. If Beijing does not take drastic action, China could see 7 to 8 percent annualised inflation rate by the middle of the year and double digit inflation later this year. In sharp contrast, the official Communist party line is that inflation will run at 4 percent this year, and that the Chinese government's capacity to combat inflation is quite strong. Athough the official inflation rate significantly understates the real rate, it is at a 28-month high.

Emergency Measures and Chinese New Year

Behind the scenes panicky officials have already released large shares of government food reserves in order to calm prices. The ministry of Civil Affairs has also ordered emergency measures to help poor Chinese cope with inflation over the Chinese New Year period, a key national holiday.

Detailed Surveys show Majority Resentment

Two recent surveys, one by a government think tank and one by the People's Bank of China, have revealed that inflation is already causing deep resentment across the world's second largest economy. A questionnaire given to 20,000 banking customers in 50 cities across China also confirmed the same trend, with 74 percent of respondents saying that prices in China are now "unbearably high".

Cause of Tiananmen Square Repeat?

Inflation remains a deeply emotional and political issue in China and the Communist Party is keenly aware that periods of high inflation have caused turmoil in the past. For example, inflation is widely blamed for having helped fuel the popular unrest that led to the Tiananmen Square protests in 1989.

Global Warning Signs

China is not alone in experiencing food inflation. Poor countries which import much of their food, such as the Philippines, Mexico, Nigeria and Pakistan, are suffering, and even many self-serve countries such as China, Russia and India, are also suffering. Signs of huge food inflation worldwide can be observed in prices of traded staples like wheat, corn and rice. Prices shot up in 2010, soaring 26 percent from June to November and brushing 2008’s peaks, according to the United Nations’ FAO Food Price Index. High prices particularly deprive the poor, who spend as much as half of their income on food. The market still functions, but at riot-inducingly high prices. Food inflation produced riots around the world in 2008 and 1974.

No Shortages

Contrary to popular opinion, food inflation is not being driven by shortages at present. Worldwide demand for staple grains is predicted to rise 2 percent in 2011, even as production falls 4 percent. Given that grain reserves run to almost 17 percent of total usage, according to Rabobank, this is a safe buffer. Nor are the main problems population trends or changing eating habits in emerging markets, which cannot alter the price of food so dramatically in such a short period of a few months.

What is making inflation worse?

I. Quantitative Easing and Loose Monetary Policy

Governments around the world, from the US to China, have effectively printed money, via Quantitative Easing, to help their economies recover. This has created two side effects.

1. Investors have bought exposure to commodities as an economic hedge and for windfall gains. Many key global commodities have already broken through record levels, a combination that spells further inflation.

2. Price of foodstuffs has been bid up as low interest rates reduce the opportunity cost of hoarding them -- especially in China, where money supply grew by almost 20 percent in 2010.

II. Unbearable Price of Fuel

The second flash point is the oil price at more than USD 80 for several months, which:

1. Increases transport costs for food. Fuel powers the trucks and planes that move the produce.

2. Encourages diverting grains into biofuels, which become competitive when oil hits USD 60 per barrel. The US, which supplies two-thirds of the world’s corn exports, diverted huge amounts into biofuel in the run-up to 2008’s crisis, causing 70 percent of the rise in corn prices, according to the IMF.

3. Raises the price of fertilisers which are mostly made from gas- and oil-based products.

4. Increases harvesting, processing and packaging costs.

III. Freezing Winter and Commodities

Unfortunately, harsher winter conditions in the Northern Hemisphere are also pushing up food prices.

Top Priority: China's Central Concern

China's government has been cautious so far in trying to control inflation, but at this point of spiralling prices, it is left with no option other than to focus on cutting inflation dramatically over coming months. In 2011, inflation has now become the central concern for the Communist Party of China, which is increasingly fearful of social unrest as a direct result of escalating prices of food and essentials.

Rate Hikes, Lending Controls and Exchange Rates

We understand that at least four more interest rate hikes over the coming three months and significant controls on bank lending, particularly between January and March, are now being considered. China is likely to impose higher reserve ratios on its banks and to allow its currency to rise in order to fend off the threat of "hot money" inflows from overseas speculators. Major state-owned companies have also been ordered to funnel more profits to the state, which the government hopes will reduce their ability to invest and so help stop the economy overheating further.

Key question: will fiscal and monetary policy be enough to curb inflation or will China need to let the yuan appreciate substantially to tame inflation?

Consequences of Rapid Rate Rises on Global Markets

The prospect of at least four further interest rate rises in China is likely not just to impact on domestic financial and property markets but also alarm international markets, which have tumbled in shock every time China raises rates in recent months. Already, Chinese bonds have become the worst performing among Asian markets, returning just 1.7 percent in 2010. The Shanghai Stock Exchange, meanwhile, has fallen by 16 percent over the year, making it the worst amongst all emerging equity markets. This suggests that Chinese investors fear that inflation is spinning out of control.

Hyperinflation, Panic Policy and Domino Effects

Chinese children and adults are equally aware that one of the reasons the Communists came to power was because hyperinflation undermined the previous nationalist government. Panicked policy-makers who turn to interest rate hikes and other draconian measures may bring about myriad unintended consequences. Heavy-handed action to calm inflation and slow the economy will likely have profound consequences for the rest of the world.

Behind the Curve

Although China raised interest rates twice and increased bank reserve requirement ratios six times in 2010 as it moved to normalise monetary policy to absorb excess liquidity, concerns are being expressed within and without China that authorities may have waited too long and done too little to deal with inflation. Actions required to control inflation will now have to be more severe, threatening the traditional double digit annual GDP growth and risking a hard landing.

Conclusion: World Red Alert?

I. Taming The Inflation Monster

Why is high inflation to be feared not just in China but anywhere in the world? Chinese policy makers are now battling the downsides of the credit boom they stoked through stimulus spending and low interest rates in 2009 and 2010, in order to keep up expansion in the face of collapsed exports and falling confidence. High inflation undermines the legitimacy of government and this is the key issue for China and other countries facing similar concerns.

II. The Next Global Financial Crisis

Chinese inflation crisis coincides with the resurgence of the eurozone debt crisis and growing US sovereign debt funding requirements. These three parallel developments pose conditions for a perfect storm, which could overwhelm world markets:

1. Dramatic efforts to control China's inflation end up damaging the national and international growth trajectory;
2. Eurozone debt crisis in PIIGS - Portugal, Ireland, Italy, Greece and Spain -- spills over into core European countries, ie, France and Germany;
3. US sovereign debt funding requirements spark an economic crisis as world becomes reluctant to fund new issues of American government and corporate debt at historically low rates.

These three converging dynamics carry the joint capacity to derail the global economic recovery by damaging business confidence, world trade and GDP growth. What we considered to be low probability high impact scenarios a year or two ago, have now become high probability high impact scenarios.

[ENDS]

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